High-Earning Retirement Savers Are Losing Some of Their 401(k) Tax Break

Savers ages 50 and older can make catch-up contributions in their 401(k) accounts each year, with eligible workers allowed to put an extra $7,500 into their accounts, for a total of $30,000, this year.

Starting next year, those catch-up funds will be funneled only into after-tax Roth accounts for those who earned more than $145,000 the previous year. The change is part of a set of new rules Congress passed in December. In 2022, 16% of eligible participants took advantage of catch-ups, according to Vanguard Group.

This change means many workers will pay taxes on their catch-up money up front during high-earning years, rather than in retirement when they may be in a lower tax bracket. It stands to reshape how many Americans save for retirement and create financial and estate-planning strategies.

Making catch-up contributions with pretax money has been a boon for high earners. For example, someone in a 35% bracket would receive a $2,625 tax deduction for a $7,500 catch-up contribution, while someone in the 22% bracket would deduct $1,650.

While some Americans will pay more in taxes under the new rules, financial advisers say there will be a benefit to getting near-retirees to put more money into a Roth, where money grows and can be withdrawn tax-free. The changes don’t apply to IRAs, which allow a catch-up contribution in 2023 of $1,000 for savers 50 and over on top of the $6,500 annual limit.

“The Roth is such a powerful savings tool that I try to have at least some dollars going into that bucket for all my clients, regardless of tax bracket,” said Cristina Guglielmetti, a financial adviser in Brooklyn, N.Y.

Benefits of Roth

Retirees with nest eggs in traditional accounts must pay ordinary income tax when they withdraw the money. In Roth accounts, workers can build a pot of tax-free money to spend in years in which tapping other accounts would push them into a higher tax bracket or force them to pay higher Medicare premiums.

Many assume they will be in a lower tax bracket in retirement, but that isn’t always the case, said Ed Slott, an adviser who specializes in retirement accounts.

Because high earners often amass large balances in traditional 401(k)s and individual retirement accounts, many find themselves in the same or a higher tax bracket when the Internal Revenue Service requires them to start pulling money out of those accounts at age 73.

The new requirement for catch-up contributions is a “gift to high earners” who might otherwise overlook the benefits of tax-free growth, he said.

Because Roths grow tax-free, they are better options for big savers than taxable brokerage accounts, which require owners to pay taxes annually on dividends, interest and realized capital gains, advisers say. Roths also have big advantages for heirs, who receive tax-free income.

Both Roth and traditional accounts must be liquidated over 10 years by most nonspouse beneficiaries.

Companies call for a delay

Though the change is set to kick in Jan. 1, some companies and plan providers say they need more time to meet the logistical challenges of identifying who earned more than $145,000 the previous year and retooling payroll and other systems to ensure their catch-ups go into a Roth.

More than 200 employers, 401(k) record-keepers, and payroll providers recently sent a letter to Congress requesting a two-year delay. Signed by companies including Delta Air Lines, Anheuser-Busch, and Fidelity Investments, which administers 24,800 corporate retirement accounts for employers, the letter says many won’t be able to change their systems in time to meet the deadline.

“For many of these plans, unless this requirement is delayed…their only means of compliance will be to eliminate all catch-up contributions for 2024,” the letter said.

Sharon Lukacs, executive director of the New York State Deferred Compensation Board, said the state’s $31 billion deferred compensation plan allows the 2,236 local employers using the plan to decide whether to offer a Roth. Currently, 1,200 have opted against doing so, in some cases because their payroll systems couldn’t handle Roth contributions.

So far, 150 of the 1,200 have agreed to add a Roth by Jan. 1, she said.

Currently, 30% of Fidelity’s 24,800 401(k) clients lack a Roth feature, said Dave Gray, head of workplace retirement offerings and platforms at the Boston-based company. Unless those employers adopt a Roth option before the new law goes into effect, they will have to eliminate catch-up contributions for all of their workers, Gray said.

Payroll providers, employers and 401(k) record-keepers are working to meet the deadline, but are waiting for guidance from regulators on questions including whether they must seek permission from high earners to put their catch-up contributions into a Roth or can do so automatically, Gray said. If the guidance comes late in the year, companies might not have enough time to adjust their systems, he said.

Some retirement savings plans, including those for state employees in South Dakota and Idaho, can’t add a Roth unless their state legislatures pass laws, said Matthew Petersen, executive director of the National Association of Government Defined Contribution Administrators, which has 250 members. Some employers must negotiate with unions to add a Roth, he said.

A spokesperson for the Treasury Department said it plans to issue guidance in the near future but declined to comment on the request for a delay.

A fix from Congress

Another question hanging over catch-up contributions resulted from a drafting error in the retirement bill that Congress passed late last year, which many lawyers specializing in retirement plans interpret as prohibiting catch-up contributions for all workers starting in 2024.

In a May 23 letter to the Treasury Department and IRS, lawmakers including Sen. Mike Crapo (R., Idaho) and Rep. Richard Neal (D., Mass.) said Congress intends to “introduce technical corrections legislation” to fix that problem.

“Congress did not intend to disallow catch-up contributions,” the letter said.

By Anne Tergesen